The Concept of Classical TheoryThe classical economic theory is based on Say’s Law. Say’s Law asserts that “Supply creates its own demand” (Bortis 5). This is a clear indication that whatever the people produce is all sold. The main question that comes up in the discussion of Classical theory is why people work. The theory illustrates that people engage in work mainly to get money. In essence, the producers are compensated because of their products. They use this money to buy other people’s products. This is a clear indication that as long as people spend whether they earn, the economy will be stable. However, economic problems are manifested when the people commence saving part of the money earned. The classical theory understands that people must save since saving is crucial for the economic development and growth. Without saving in the society, there could be no investments. Investments lead to the growth of equipment, inventory and production plants.
In addition to the above, consumer goods and investment goods are vital concepts in the classical theory. In essence, production is thought to consist of two components namely; investment goods and production goods. Dutt maintains that the amount of money utilized in consumer goods is represented by letter C. On the other hand, the amount of money used in acquiring investment goods is represented by the letter I.
Considering that GDP is a total spending, GDP= C+I.
If GDP is considered as income received, GDP will, therefore, will be calculated as C+S.
Therefore, GDP= C+I or GDP=C+S.
This means that C+I=C+S.
The classical theory, therefore, believes that when aggregate demand (AD) equals aggregate supply (AS), the situation is considered as classical equilibrium. This situation cab is illustrated in both micro level and macro level. When the quantity demanded (QD) in micro level is equivalent to the quantity supplied (QS), the situation is referred to as equilibrium (Dutt 320).
As well, on the macro level, when the aggregate demanded (AD) is equivalent to the aggregate supply (AS), the situation is considered as equilibrium. This means that according to the classical balance, the Gross Domestic Product (GDP) at which aggregate demand was equivalent to the aggregate supply, the economy is at full employment (Bortis 5).
The Concept of Keynesian Theory
The Keynesian theory was developed as a response to the Great Depression. This is the time when the classical theory was the dominant of the school of economic thought. The main reason for the development of the Keynesian theory is John Maynard Keynes question about the classical system. Keynes asked the following question “If supply creates its own demand, why are we having a worldwide depression?” The other matter that Keynes wanted answered is what happens if investment and savings were not equal. According to him, this situation will result in two fundamental economic challenges.
The first challenge is that if the savings were more than the investments, there would be greater level of unemployment. This means that a lot of people will be without work to do and since they can’t generate income, their living standards could be substantially low. The second effect that will occur is that not everything that is produced will be sold. This means that a lot of the products that are being produced could be wasted.
Moreover, there are some key issues that Keynes maintained in his critique of the classical theory after the Great Depression. One of the major issues Keys noted is that saving and investment are done by different people in the society. All these people have varied reasons for saving and investing. The second issue noted is that the majority of the savings are made by individuals for only the big ticket items. As well, Keynes maintained that the majority of the investors own businesses and their primary objective is to make profits. They make this investment approach whenever they are confident that they will make substantial profits. Therefore, these businesses will not invest during times when the interest rates are low since they will end up making low profits (Flaschel 7).
In his conclusions, Keynes noted that the economy was not always at, or tending toward a full employment as perceived by the classical theory. Therefore, he came up with three possible equilibriums namely: below full employment, at full employment, and above full employment.
Blinder asserts that the Modified Keynesian Aggregate Supply Curve states that output can be raised without raising the prices as the economy works its way out of a depression. In this case, the supply curve is flat. On the contrary, prices may commence rising due to the use of more resources and the development of bottlenecks. As a result of this situation, the aggregate supply curve (ASC) begins to move upward. However, at a real Gross Domestic Product (GDP), that is $6 trillion output cannot be raised anymore. This situation is considered as full employment (Flaschel 8).
Therefore, it can be concluded that the Keynesian theory states that “Demand creates its own supply” (Bortis 8). This is in connection with Keynes assertion that aggregate demand (AD) is the prime lover of the economy. Thus, this situation is illustrated in two key aspects. The first and most crucial aspect is that aggregate demand (AD) controls the level; of output and employment in a given economy. The second point is that companies produce only the level of goods and services that they believe that customers will be planning to purchase. In this case, the buyers include the government, investors, consumers, and even foreigners.
Further Differences Between the Keynesian Theory and The Classical Theory
In addition to the above concepts that differentiate the two theories, it is imperative to note there are other factors that are crucial in distinguishing them. One of the major of these factors is the shape of the long-run aggregate supply (LRAS). In the classical theory, the long-term aggregate supply (LRAS) is inelastic. This means that real Gross Domestic Product (GDP) is determined by supply side factors. Some of the major of these factors include labor, capital, and investment levels. On the contrary, the Keynesian theory views the LRAS in a varied manner. In essence, they consider that economy can be full capacity in the long run. This is a clear indication that the Keynesian theory concentrates on the role of aggregate demand (AD) in causing and overcoming recession (Blinder 4).
The other difference between the two theories is demonstrated by demand deficient unemployment. The Keynesian theory view on the cause of unemployment varies from the classical view of unemployment. According to the classical theorists, unemployment is primarily caused by the supply side factors. On the other hand, Keynesian theory emphasizes on demand deficient unemployment.
Besides, the flexibility of prices and wages indicate some differences between the two theories. The classical theory assumes that prices and wages are flexible and markets will end up being clear and efficient. On the contrary, Keynesian theory asserts that wages are not normally flexible. In the real world the wages are considered as sticky downwards due to worker’s resistance to normal pay cuts (Flaschel 11).
In conclusion, the theories vary in the level of confidence and rationality. The classical theorists assume that people are rational and their confidence is not always shaken. However, the Keynesian theorists and economists predict that the confidence of people involved in business can collapse during difficult times contributing to a fall in both Investment (I) and Demand.
- A Model of the Macro-Economy: Aggregate Demand and Supply. Retrieved 3rd October 3, 2016 from http://www.harpercollege.edu/mhealy/eco212i/lectures/asad/asad.htm
- Bortis, Heinrich. “19. Keynes and the Classics: Notes on the Monetary Theory of Production.” Modern Theories of Money: The nature and role of money in capitalist economies (2003): 411.
- Blinder, Alan S. “Keynesian economics.” The concise encyclopedia of economics 2.008 (2008).
- Dutt, Amitava Krishna. “Aggregate demand, aggregate supply and economic growth.” International Review of Applied Economics 20.3 (2006): 319-336.
- Keynesian AS AS-AD: The Keynesian System (IV): Aggregate Supply and Demand. Retrieved 3rd October 3, 2016 from http://web.uconn.edu/cunningham/econ309/keyne-asad.pdf
- Flaschel, Peter. Keynes, the “Classics,” and the “New Classics”: A Simple Presentation of Basic Differences. Springer Berlin Heidelberg, 2009.
- The AS–AD Model: Aggregate Supply & Aggregate Demand. Retrieved 3rd October 3, 2016 retrieved from http://faculty.riohondo.edu/mjavanmard/Slavinpowerpoint/PDF/ch11asadinteraction.pdf
